Module 2 - Sources of Finance

Question 1

Matching (sources of finance)

Answer 1

The type of finance should broadly match the nature of its purpose e.g. long term funds for assets with a long life

Question 2

Long term sources of finance

Answer 2

• ordinary share capital
• preference share capital
• bonds

Question 3

Ordinary share capital

Answer 3

• equity
• permanent capital
• high level risk, high returns
• sole beneficiary of any upward shift in the market value of the firm
• no guaranteed minimum income or available return

Question 4

5 ways of issuing ordinary share capital

Answer 4

1. offer for sale
2. offer for subscription
3. placing
4. rights issue
5. crowdfunding

Question 5

Offer for subscription

Answer 5

Allows the company to state in advance of the share issue that if the share issue does not raise enough money it will be aborted

Question 6

Placing

Answer 6

Shares not offered to the general public but sold privately to selected investors - least expensive and common for small issues

Question 7

Rights issue

Answer 7

Existing shareholders are offered opportunity to purchase further shares pro rate to their existing holding. Can sell right to third party.

Question 8

Advantages of issuing equity share capital

Answer 8

• permanent capital

- flexible returns

Question 9

Disadvantages of issuing equity share capital

Answer 9

• loss of control
• high costs
• non tax-deductible

Question 10

Preference share capital

Answer 10

• not entitled to vote
• may or may not be listed on stock exchange
• usually fixed percentage of nominal value
• no guarantee of dividend
• paid before ordinary shares
• prior claim on assets in event of liquidation

Question 11

Conditions that may be attached to preference shares

Answer 11

• cumulation
• redemption
• convertibility (at shareholder’s discretion)
• participation (in profits above a certain minimum)

Question 12

Advantages of issuing preference share capital

Answer 12

• lack of dilution
• no loss of control over profits
• dividend doesn’t have to be paid
• alternative to debt

Question 13

Disadvantages of issuing preference share capital

Answer 13

• high costs
• non-tax deductible
• expectation to pay

Question 14

Reason for issuing bonds

Answer 14

a way for a company to raise finance through borrowing without going through a bank

Question 15

Floating rate on bonds

Answer 15

Charged at a set margin over a base rate such as LIBOR

Question 16

Bonds

Answer 16

• may or may not be listed on stock exchange
• can be credit rated
• commonly interest bearing
• must be paid before dividends
• fixed or floating interest

Question 17

Advantages of issuing bonds

Answer 17

• cost (cheaper to issue debt capital)

- tax deductible interest payments

Question 18

Disadvantages of issuing bonds

Answer 18

• security (some bonds are secured)

- lack of flexibility

Question 19

Medium term sources of finance

Answer 19

1. term loans
2. hire purchase
3. lease contracts
4. venture capital
5. business angels

Question 20

Term loans

Answer 20

• typically obtained from banks for a few years
• repayable in a fixed pattern - not necessarily equal instalments
• secured by a fixed or floating charge
• likely to impose covenants
• interest charged at a fixed or floating rate
• default if payment is missed and ban can demand immediate full repayment

Question 21

Hire purchase

Answer 21

• purchase and own and asset but allow the hiree to use the asset in return for regular payments
• charge a fixed interest rate on capital sum effectively borrowed
• equal periodic payments over life of agreement
• at the end ownership passes to hiree

Question 22

Lease contracts

Answer 22

• obtain the right to use assets
• lessor (provider of the asset
• lessee (user of asset)
• debt finance
• lessor retains ownership
• all risks and rewards of ownership other than legal title
• if short term no right to use capitalisation

Question 23

Reasons for leasing

Answer 23

• not enough funds
• asset regularly superseded
• security of a lease is limited to asset held under lease
• interest payments on leases are tax deductible

Question 24

Venture capital

Answer 24

• new or expanding companies can obtain funding from a venture capitalist
• high risk high return
• provides funds in return for stake
• usually 3-5 years
• can be equity or debt or both
• usually a member of staff appointed to board

Question 25

Business angels

Answer 25

• wealthy individuals
• usually have business expertise
• invest money in new or expanding companies in return for shares
• usually willing to invest earlier than venture capitalist
• assist business with expertise
• invest medium term then exit

Question 26

Short term sources of finance

Answer 26

1. overdraft

2. factoring

Question 27

Overdraft

Answer 27

• loan facility on bank current account
• interest payable on amount overdrawn
• cheap way to finance fluctuating requirement
• expensive for long term borrowing
• repayable on demand

Question 28

Factoring

Answer 28

1. Provision of finance (80% of invoice for fee)
2. sales ledger admin (2% rev fee) - chases debtors
3. credit insurance